Question

You are a crude oil dealer. You intend to sell 40,000 barrels of crude oil in December. Each contract calls for delivery of 1,000 barrels of oil. Current futures price of one barrel of crude oil is $70. You believe that there are only four possible oil prices in December which are $50, $60, $70, and $80. i. Explain what action you would take to protect from changes in oil prices in December. Provide reasons for your action. ii. Calculate the total proceeds for each of the possible prices in December. Question 3 3 marks

Answer 1

i. buy put option

ii. Proceeds will be as follows:

$50 : 2,000,000

$60 : 2,400,000

$70 : 2,800,000

$80 : 3,200,000

Step-by-step explanation:

i. A put is option is one in which buyer of the option has a right to sell the asset at an agreed price at a later date. There can be a premium on the purchase of an option but its safe to buy an option to reduce risk exposure.

ii. $50 : 2,000,000 (40,000 barrels * $50)

$60 : 2,400,000 (40,000 barrels * $60)

$70 : 2,800,000 (40,000 barrels * $70)

$80 : 3,200,000 (40,000 barrels * $80)